Monday, June 6, 2011

The Future of Physical Gold (Part III - The Final Realization)

In Part I and Part II of this series, Dialectic Foundations and The Evolution of Value, we discussed how the material conditions of human existence drove the evolution of the capitalist political economy, and how wealth came to be created through the production of "surplus value" from commodity inputs (= its objective "use-value" minus its "exchange-value"). The fruits of surplus value were increasingly concentrated among those who controlled productive assets and managed cash flows (finance) in the "wealth accumulation" circuit (M-C-M+).

However, this value cannot be realized without monetizing the exchange-values of finished products or services in a market. The realization of surplus value becomes a significant barrier to capitalist growth when workers cannot keep up pace through proportionally increasing wages in an unfriendly, time-constrained environment (only 24 hours in a day), while thousands are also displaced by technological gains and added to the "reserve labor army" of the unemployed. The latter process was heavily influenced by the discovery of fossil fuels, which allowed machinery capital to generate a higher ratio of surplus value than labor.

As the dialectic struggle between workers and capitalists progressed, certain political concessions had to be made by the latter so they could continue recycling surplus value in consumer and investment markets. For example, a minimum wage had to be set, basic working conditions had to be improved and monopolies had to be prevented or disbanded so companies within an industry could theoretically offer competitive prices and wages. The "Socialist" revolutions of Russia, Eastern Europe, Latin America and China provide extreme examples of political concessions that did little to alter the fundamental reality of workers living in a world marked by capitalist relations of production.

Many "progressive" labor policies became more prominent in the West after World War II, when aggressive "safety nets" were created and labor was allowed to organize at larger scales. This trend was largely aided by the natural dialectic pullback from the perceived failures of capitalism during the Great Depression, which ultimately only ended for the the world through a global war effort. The monetary circuit (M-C-M+) of surplus value, however, cannot function well when labor's share of power is growing, which caused the "neo-liberal revolution" of the 1970s to reverse the trend and give an unprecedented wealth advantage to the purveyors of speculative financial capital.

Over the last 40 years, gains in productivity and income have continued to be distributed more unequally, as capitalists took their investments to parts of the world with much less influence of labor and, therefore, much fewer regulations of capital. This transition allowed transnational capitalists to reduce their costs and offer lower prices to consumers in their "home" country, as those developed economies oriented their growth towards finance and other related services.

It also allowed financiers to usurp the wealth extraction role of capitalist producers to a large degree, since many productive firms could only remain competitive within an industry when they were continuously financed; a distinct feature of capitalism that Marx terms "the coercive laws of competition". These laws should sound familiar, because they are the same ones that force the capitalist producer to continue re-investing portions of their accumulated wealth in the M-C-M+ circuit.

The system also relied on explicit coercive policies by the state to help organize and maintain the centralization of capital (selective private property rights, corrupt court systems, favorably complex tax structures, discriminatory regulation, etc.). For example, the state-led process of subsidizing financial markets during every recession over the last 30-40 years has helped to concentrate even more wealth, as larger institutions were subsidized for losses, continued their operations and soaked up the productive/financial assets of the smaller ones at huge discounts.

David Harvey, a sociologist and historian with a Marxist perspective, provides a very creative animated summary of how the dialectic evolution of financial capitalism has progressed over the last 40 years, in the following video [starts 5 minutes into 11 minutes - obtained fromNaked Capitalism]:

The striking result of the wealth inequality generated over time by financial capitalism is partially captured by the following graphs, featured in Parts I and II of my article series, The Math is Different At the Top, as well as the additional data points I have included below them for purposes of this article:

U.S. Statistics

Global Statistics

The U.S., Japan and Europe are obviously the "central hubs" of global wealth, and comprised 77% of the pyramid's upper-level ($100,000-$1M) when it was released last year. [1]. In the U.S., almost 6.5M people have dropped out of the labor force since April 2008, with close to 550K of them dropping since January of this year. According to Mish Shedlock's calculations, in which 60% of these people want a job but cannot find one, the revised unemployment rate would be around 11.2% if those people were added back into the labor force. [2]. Are all of these unemployed workers receiving public revenues that keep will them happy and spending?

Well, according to the WSJ, at least 5.5M of them (nearly 30%) are not receiving any unemployment benefits. [3]. Of those jobs that do happen to exist, 41% of them are classified as "low income" positions. [4]. More than 44M Americans ore on food stamps right now, which is about a 90% increase since 2007 [5], and a study indicates that Americans are currently falling $6.6T short of what they "need" to retire. The Personal Consumption Expenditures component of Q1 2011 GDP dropped nearly 20% from last quarter, and the GDP itself came in at 1.8% (~1.2% came from "inventories"). [6].

Meanwhile, across the Atlantic, the European population is in a similar position, and countries such as Ireland, Greece, Spain, Portugal and Italy can barely afford to support their private economies through public deficits anymore. That fact is especially troubling for a country like Spain, which is financially closer to the EU's "center" than its "periphery", and whose educated youth suffer a jobless rate north of 40%. [7]. All of those Spanish "homeowners", like U.S. "homeowners", are watching their home equity, already purchased with debt repayments, rapidly evaporate while the real asset owners (large banks) are being subsidized for a large portion of their losses. [8].

Finally, Japan was in a low-growth environment for decades (~1.5%), has the highest public debt/GDP ratio in the world (225% as of 2010) and had an unemployment rate of at least 5-6% as of 2009. However, the latter number is severely under-estimated, as evidenced by the fact that the job offer/applicant ratio had declined (40% in one year), as well as average hours worked and wages paid (~3% in one year). Of course, the recent earthquake, tsunami and nuclear meltdown (ongoing) in the country has massively impacted economic growth (subtracted ~3.7%), and it will continue to be a major factor in the upcoming months and years. [9].

So how do we know that this highly unequal wealth destruction and redistribution has resulted from structural instabilities of capitalism, as Marx and Harvey argue, rather than just corrupt state policies and an ever-increasing portion of the population being "lazy" and unproductive? It is obviously not possible to know anything for certain, but the overwhelming logical and empirical evidence suggests that the latter are merely byproducts of the former. As briefly alluded to earlier, Marx's ideas about net negative demand in the entire economy, as a sum of the commodity and monetary circuits, meant that the system necessitated certain levels of finance over time.

To overcome the conundrum of net negative demand without sacrificing economic growth for too long, at least some consumers of commodities and investments (individuals, businesses, governments) must be able to issue debt and finance their consumption. Roll curtain and enter stage left the system of endogenous (internal) financial money, which has shined over decades of periodic booms and busts around the world. Although the state is obviously needed to maintain systemic finance within an economy, it is not the primary driver of credit creation.

That role is reserved for private financial institutions that "offer" credit and the firms/households that demand borrowed capital for investment and consumption. As described earlier, the concentration and centralization of wealth in the monetary circuit of capitalism makes it practically impossible over time for firms to finance productive investments and produce returns adequate to cover their debts and other expenses, while also generating a profit. To maintain a somewhat stable and growing economy, then, both the firms and households must be able to produce artificial cash flows through the use of speculative finance.

Hyman Minsky has clearly laid out how a capitalist economy with a developed financial sector is endogenously prone to speculative credit bubbles that could ultimately result in a severe debt deflation and depression, and Dr. Steve Keen has thoroughly outlined and modeled this process in his research. [Policy Forum: Household Debt, Australian Economic Review]. As investment concerns from the last credit bubble continue to linger on (there is always a previous credit crisis in financial capitalism), firms and households only take out debt to finance relatively conservative investments. Once these investments start paying off, the investors become less risk averse and more aggressive with their projections of future revenues.

The banks are more than willing to finance these aggressive investments, since they are also optimistic about productive growth and debt repayments, and they are not practically restricted by any "fractional reserve requirement". At this point, the credit bubble takes off in full force and every investor with some pocket change to spare hops on for the ride, allowing their debt to equity ratios to rapidly balloon up. People who are not typically considered investors also jump in the inviting water, as they glimpse a chance to increase discretionary consumption and grab hold of the "American Dream". Interest rates in most credit markets remain quite low for some time during the bubble, aided by the loose monetary policy of the central bank and financial "innovation".

However, since much of the borrowed capital has been used to purchase assets or asset-based securities for the sole purpose of speculating on price appreciation, as well as goods that are not "self-liquidating" (i.e. SUVs), productive cash flows begin to dry up and some investors must start selling assets to service their debt. This tipping point will lead to decelerating asset prices and higher interest rates, making it more difficult for new borrowers to enter the asset market or existing borrowers to roll over their obligations. Eventually, the "ponzi financiers" who have taken on huge leverage ratios for pure speculation will find themselves in a seller's market, with very meager cash flows from the underlying assets and very high debt servicing costs.

Graph Showing the Correlation between Debt, Aggregate Demand and Economic Deterioration in the Age of Speculative Financial Capitalism [Obtained from "It's Just a Flesh Wound" on Dr. Keen's Debt Deflation Blog]

As these investors and financiers become insolvent, the entire financed market begins to implode in a self-reinforcing manner, in which lower asset prices lead to less revenues, lower ability to service existing debt, business layoffs, lower consumer spending, etc. which all feed back into lower prices and less affordable debt. If the system had allowed this process of debt deflation to continue unabated in the asset markets of 2008 (mainly housing), it would have eventually taken down the entire economic and political apparatuses of countries and regions around the world. The rate of debt deflation has only decelerated over the last few years due to the unprecedented intervention of governments and central banks around the world.

The latest GFC is surely the most potent crisis that capitalism has ever had to face, and therefore it is no surprise that the capitalists have tried that much harder to overcome the debt deflationary barrier through aggressive fiscal and monetary intervention since the implosion began. However, that doesn't necessarily mean their only option is to spend multiple trillions of dollars (or the equivalent amount in foreign currency) each year and monetize every single bad debt-asset on the books of private institutions. Another option would be to simply continue doing what they are doing now, albeit at a somewhat larger scale over time.

They will continue to run record deficits, but mostly spend that money for the benefit of the "defense" industry, financial institutions, energy corporations, big agribusiness, etc. Entitlement spending is certainly a huge component of the budget, but it has become increasingly evident that most taxpayers and retirees will be forced to bear the brunt of the "austerity" plans that are designed to make them "live within their means". As the housing market dips back down hard (the Case-Shiller index of home prices has fallen ~6% since last year [10]), mortgage-backed assets will be monetized in some cases, and left to the whims of "free market" forces in others, depending on how much political influence the owners of such assets have.

The point, then, is to exercise a degree of control over the deflationary process, and make sure the losses are properly socialized among those who can least afford them. There is very little blood left to squeeze from the collective turnip of human civilization, but our financial owners will not be satisfied until they get every last drop. Whether they are successful or not in this aim is largely irrelevant for our current discussion, though, because the damage has already been done. People who used to identify themselves as part of the "first-world" and "middle-class" will watch those labels "melt into air" just as quickly as their wealth.

With these dynamics revealed, it becomes clear that physical gold as an independent monetary asset could ideally be a great receptacle for those with enough excess wealth to save, but it would be valued entirely differently by that class who desires to constantly accumulate wealth and is ever-so important to the financial capitalist system - the financial capitalist. As discussed in Part II, it may not be valued in the capitalist system at all, beyond whatever limited surplus value it provides as a commodity in the production of goods and as a speculative investment play.

The reason is because a new global and stable "wealth reserve" will not aid the system in replenishing aggregate demand and maintaining economic growth. Some may argue that inflating away currency-based debts will alleviate the present burden of insufficient demand in both consumer and investment markets, by freeing up much more money for people to spend and invest. For example, the theory of Freegold argues that a process of dollar hyperinflation ("HI") will inevitably occur soon, during which a new global financial system and gold-based monetary order will arise.

The physical gold will allegedly recapitalize the major banking sectors and governments of the world, and that will then allow businesses and consumers to continue financing productive investments in their regional or national currencies. [Deflation or Hyperinflation?]. It is presumed that economic growth will once again be left unencumbered after a relatively short period of major monetary transformation. Even assuming this process actually did occur, we must still ask ourselves how it would realistically affect the dynamics of Marx's "realization problem".

The financial capitalists unconditionally require an expanding circuit of capital, in which monetary capital produces greater exchange-values over time (remember, the use-value of money = its ability to produce future exchange-value), and a portion of such values are continuously monetized for profits. The value of gold under the Freegold system would be inherently constrained, since it is meant to sit still and absorb some excess currency wealth, while the majority of people in the world still find themselves with tiny scraps of wealth to save, spend or invest in the first place.

The latter fact is especially true when we consider that most consumers in the developed world hold a large portion of their savings in fiat currency-based accounts. Indeed, Freegold advocates make it quite clear that HI will act as a rapid means of socializing the investment losses on the books of a few large institutions, and the super-wealthy individuals that own/manage them, throughout the productive economy via currency devaluation. If you happen to be saving most of your excess currency wealth in physical gold before HI really sets in, then perhaps you will be able to at least preserve that wealth, but how many people can we reasonably expect to be positioned in such a way?

ME: "What are the chances that the majority of people who find themselves invested in U.S. government bonds and the dollar will get anything close to a return on their investment over 10, 20 or 30 years? The answer to that is probably a massively negative percentage, because the psychological pain of holding on for that long will be even worse than the total wipe out itself. However, the herd typically doesn't figure out how close they were to the edge of the cliff until after they are tumbling down the other side." [Welcome to Slaughterhouse-Finance]

In addition, the prospect of "net producers" placing significant excess wealth in gold would leave even fewer profits for the capitalist's to realize from monetizing their goods and services in consumer and investment markets, which means fewer profits for the financiers who now control production. The aggregate level of consumer purchasing power at a given time would necessarily drop, because "fast" money would be traded to the capitalist class for dormant gold. For the above structural reasons, it is highly unlikely that the economic system of Freegold ever takes hold at a scale even close to that which its advocates envision.

That, in turn, means that investors or "savers" should not expect their current gold holdings to skyrocket in value to the equivalent of at least $55,000 in purchasing power anytime soon (as suggested in FOFOA's The Value of Gold). That prediction is based on a flawed conception of value in the capitalist economy, as explained in Part II - The Evolution of Value, and therefore fails to account for the "realization problem". Freegold views the future dollar HI event and the resulting destruction of the dollar's role as the global reserve asset as a wealth transfer from "easy money" debtors to "hard money" savers (those who place excess productive capacity into physical gold).

Perhaps this process is an accurate description, at least to some significant extent, but that means the debtors are necessarily defined as anyone who does not have a majority of his/her savings in physical gold. That definition, in turn, encompasses almost every worker, investor and "saver" in the developed world and many in emerging economies as well. It really only excludes, of course, the major institutions and super-wealthy individuals (and their political apparatuses) who control the means of production, sell toxic debt-assets to taxpayers at face-value and had previously extracted massive amounts of energy, resources and hard capital from the rest of the world.

If these people are almost instantly given 10-20x the purchasing power they already receive from their current physical gold holdings, then they will truly be the "demand of last resort" for consumption and investment in the markets of our global capitalist economy. That is wholly incompatible with the capitalist model of economic growth, which relies on the constant expansion of Marx's monetary and commodity circuits, in which surplus value is created and realized, respectively. It should also be noted that the natural processes of demographic shifts, climate change and energy/resource depletion (peak oil) will severely constrain productive income gains, making realization of value even more difficult.

Therefore, it is very unlikely that the current crises of capitalism will lead to a new reserve system based on physical gold, and is instead likely that they will lead to systemic collapse of financial and productive markets around the world. In the final part of this series, Part IV, we will discuss what this process of collapse really means for physical gold as a means of preserving wealth over time. The discussion will focus solely on financial collapse, rather than the demographic/environmental issues mentioned above, but the latter should obviously not be ignored when considering various means of preserving "wealth".

With regards to systemic finance, the realistic likelihoods of short-term deflation and HI are obviously very important considerations, as well as the specific properties of locations in which financial deterioration occurs. These properties may belong to anything from one's region or country to one's state, local community and household. As the trend towards centralization and concentration of capital grinds to a halt, our perceptions of a unified and "small" global society will also give way, as we are forced to observe the simple and enormous world existing right in front of our eyes and at our feet.

"All that is solid melts into air, all that is holy is profaned, and man is at last compelled to face with sober senses, his real conditions of life, and his relations with his kind."
-Karl Marx and Frederich Engels, The Communist Manifesto